Real Money

Placer Dome Terms Burn Convertible Traders

Barrick's hostile offer leads to a bath for arbitragers.

Convertible arbitragers usually welcome volatility, but not the kind that afflicted their bets Monday on Placer Dome ( PDG).

Common shares of the Vancouver-based gold miner surged 21% after rival Barrick Gold ( ABX) unveiled a $9.2 billion unsolicited bid for its Canadian mining rival. The hostile bid includes a proration formula that is likely to end up paying Placer shareholders 87% of the price in Barrick stock, the rest in cash.

Placer Dome's board said it is considering the offer.

Many holders of the Placer Dome 2.75% convertible bond maturing in 2023 got hurt in the trade. As is often the case in convertible arbitrage, most hedge funds were long the bond and short the underlying stock. On Monday, the appreciation in Placer Dome's stock caused a significant loss on the short side of the trade. Problematically, the rise in the bond wasn't enough to offset that pain.

"The bond is actively quoted, and this is the convertible story of the day," said a trader who has holdings the convertible trade.

The mathematics of convertible arbitrage are esoteric. Roughly speaking, the loss to shorts created by the 21% rise in Placer's common shares was not offset by the 5% gain in the price of its bonds. Traders use models to compensate for the securities' differing volatilities, but in this case, the hedge was less than perfect.

Traders said the price increase in Placer's convertible debt was muted because the proposed deal is a mix of cash and stock. "The maximum amount of cash to be paid by Barrick will be approximately $1.224 billion, and the maximum number of Barrick common shares to be issued will be approximately 303 million, taking into account the conversion of Placer Dome's outstanding convertible debt securities and outstanding share options," according to the press release detailing the bid.